CFA Institute CFA Institute Certifications CFA-LEVEL-1 Questions & Answers

• Question 1251:

  Conrad Corp. has an investment project with the following cash flows: TimeProject Cash Flows 0-$1,000 2-300 4-700 The company's WACC is 12 percent. What is the project's modified internal rate of return (MIRR)?

  A. 5.68%

  B. 3.95%

  C. 6.83%

  D. 3.20%

  E. 2.63%

  Correct Answer: B

  Find the present value of the outflows:

  t = 0: -1,000

  t = 2: N = 2, I = 12, PMT = 0, FV = 300, and solve for PV = -$239.1582.

  t = 4: N = 4, I = 12, PMT = 0, FV = 700, and solve for PV = -$444.8627.

  Total PV(Costs) = -$1,000 - $239.1582 - $444.8627 = -$1,684.0209.

  Find the future value of the inflows:

  t = 1: N = 4, I = 12, PV = -200, PMT = 0, and solve for FV = $314.7039.

  t = 3: N = 2, I = 12, PV = -900, PMT = 0, and solve for FV = $1,128.96.

  t = 5: N = 0, I = 12, PV = -600, PMT = 0, and solve for FV = $600.

  Total FV(Inflows) = $314.7039 + $1,128.96 + $600 = $2,043.6639.

  Then find the MIRR:

  N = 5

  PV = -1,684.0209

  PMT = 0

  FV = 2,043.6639

  Solve for MIRR = I = 3.9471%.

• Question 1252:

  Empirical testing has confirmed the validity of which of the following dividend theories?

  A. Tax differential theory.

  B. Empirical testing has not produced any definitive results.

  C. Empirical testing has produced some evidence in support of each of these theories.

  D. Dividend irrelevance, or Modigliani-Miller, theory.

  E. Bird-in-the-hand theory.

  Correct Answer: C

  These 3 theories have produced unclear empirical tests because of two reasons: 1. For a valid statistical test, things other than dividend policy must be held constant, and 2. We must be able to measure with a high degree of accuracy each sample firm's cost of equity. Neither of these two conditions holds.

• Question 1253:

  A firm's earnings break point equals $98 million. Its net income is $58 million and it is committed to a dividend payout ratio of 30%. It's after-tax cost of debt equals 9% and its shareholders demand an expected rate of return of 15%. The firm's WACC equals ________.

  A. 12.2%

  B. 9.8%

  C. 11.5

  D. 10.3%

  Correct Answer: C

  The retained earnings of the firm = $58*0.7 = $40.6 million. If the earnings breakpoint is $98 million then the firm must issue $(98-40.6) = $57.4 million in debt to maintain constant D/E ratio. This implies that the firm's D/E ratio equals 57.4/40.6 = 1.41. Debt comprises 57.4/98 = 58.57% of the capital structure. Therefore, WACC = 0.5857*0.09 + 0.4143*15% = 11.49%.

• Question 1254:

  Moynihan Motors has a cost of capital of 10.25 percent. The firm has two normal projects of equal risk. Project A has an internal rate of return of 14 percent, while Project B has an internal rate of return of 12.25 percent. Which of the following statements is most correct?

  A. If the crossover rate (i.e., the rate at which the Project's NPV profiles intersect) is 8 percent, Project A will have a lower net present value than Project B.

  B. All of these answers are correct.

  C. If the projects are mutually exclusive, the firm should always select Project A.

  D. None of these answers are correct.

  E. Both projects have a positive net present value.

  Correct Answer: E

  If the projects were independent, both should be accepted. They both have an IRR greater than the cost of capital, so they have positive NPVs. If the cost of capital were above 14%, both projects should be rejected. Project B will have a higher NPV at discount rates below 8% and Project A will have a higher NPV at discount rates above 8%.

• Question 1255:

  Adams Audio is considering whether to make an investment in a new type of technology. Which of the following factors should the company consider when it decides whether to undertake the investment?

  A. None of these factors should be considered.

  B. The installation costs for the new equipment for the new technology are very high.

  C. The new technology will affect the cash flows produced by its other operations.

  D. If the investment is not made, then the company will be able to sell one of its laboratories for $2 million.

  E. All of these factors should be considered.

  Correct Answer: E

  These are all incremental cash flows which change the firm's total cash flow that occurs as a direct result of accepting the project, and should all be considered

• Question 1256:

  Which of the following statements about capital structure theory is most correct?

  A. In general, an increase in the corporate tax rate would cause firms to use less debt in their capital structures.

  B. Signaling theory suggests firms should in normal times maintain reserve-borrowing capacity which can be used if an especially good investment opportunity comes along.

  C. All of the statements are correct.

  D. None of the statements are correct.

  E. According to the "trade-off theory," a decrease in the costs of debt would lead firms to increase equity financing in their capital structures.

  Correct Answer: B

  An increase in the corporate tax rate reduces the after-tax cost of debt making it more attractive relative to equity. Thus, firms might be expected to use more debt. The trade-off theory of leverage states a firm trades off the benefits of debt financing (favorable corporate tax treatment) against the higher interest rates and bankruptcy costs.

• Question 1257:

  You have recently accepted a one-year employment term by a firm. The firm has given you the option of receiving your salary as a lump sum value of $30,000 at the end of the year or as 12 monthly payments of $2,400 starting one month after you start work. If your relevant discount rate is 2 percent per month, then which salary options would you prefer? (Ignore taxes, risk, and consumption needs.)

  A. Monthly payments, since you do not have to wait so long to receive your money.

  B. Monthly payments, since it has the larger present value.

  C. The lump sum payment, since it has the larger present value.

  D. Either one, since they have the same present value.

  E. The lump sum payment, since it has the larger future value.

  Correct Answer: B

  Monthly option PV = $2,400(PVIFA(2%,12)) = $2,400(10.5753) = $25,380.72. Annual option PV = $30,000(PVIF(2%,12)) = $30,000(0.7885) = $23,655.

• Question 1258:

  Which of the following is most likely to encourage a company to use more debt in its capital structure?

  A. All of these answers are correct.

  B. An increase in unit production.

  C. An increase in the corporate tax rate.

  D. An increase in the company's degree of operating leverage.

  E. An increase in the personal tax rate.

  Correct Answer: C

  A major reason for using debt is that interest is deductible, which lowers the effective cost of debt.

• Question 1259:

  A firm has a dividend growth rate of 2.8%. It typically pays out 48% of its earnings as dividends. Recently, it paid out $2.4 per share dividend and the required rate of return on its stock is 13%. The firm's return on equity equals ________.

  A. 5.83%

  B. 5.38%

  C. insufficient information

  D. 12.19%

  Correct Answer: B

  g = ROE*(1 - dividend payout ratio). Therefore, ROE = 0.028/(1 - 0.48) = 5.38%.

• Question 1260:

  Which of the following statements is most correct?

  A. None of the statements are correct.

  B. The discounted payback method solves all the problems associated with the payback method.

  C. The NPV method is appealing to some managers because it produces a dollar amount upon which to base decisions rather than a IRR method.

  D. All of the statements are correct.

  E. For independent projects, the decision to accept or reject will always be the same using either the IRR method or the NPV method.

  Correct Answer: E

  For mutually exclusive projects, a conflict can exist if the cost of capital is less than the crossover rate.